What Does Management Need to Do . . . On A Profits Interests Valuation?

No Worries. This Job’s Not THAT Terrifying.

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Information for CFOs, finance leaders, and accountants in private equity.

Profits interests are the #1 form of equity-based compensation used in private equity.

All private equity companies that issue these must comply with specific valuation requirements for financial reporting. Under ASC 718.

This often means management will need to engage the services of a valuation expert (me)??.

One Of The First Things My Client’s Ask

>>> What do you need from me?

Yes, there are things you have to get together for the valuation.

Good news there. Almost always things you will already have available.??

?. . . and way easier than hanging from steel girders a thousand feet up building a skyscraper.

Although . . . not getting it right can become somewhat perilous.

Surprises. Fire Drills. Delay. Increased Costs.

Avoid a disaster by being prepared.

Here’s what you need to do.

At The Start Of A Project

My clients get an initial list of the information they need to provide.

Summarized here:

?? Grant Date(s) of Profits Interests

?? Capitalization (Cap) Table

?? Details on Profits Interests

?? Shareholder Agreements

?? Projected Time to Exit

?? Estimates of Preferences

?? Business (Total Equity) Value

We schedule time to go over the list, answer questions, make sure everything is understood. Add, remove, or modify things.

Items on this list can be related to each other. For example, # 1, the grant date(s), relates to all the others.

We work with you to get everything sorted out. So it's clear what is needed.

Note: You can find additional explanation on all these items later in this article where you see ? Inside Tips.

Clients then upload items to a secure cloud site or send over in an email. These can go all together, item by item, or however it works best.

? Inside Tip: Projects are faster and more efficient when everything gets sent over at the same time. Even if it takes a little while for you to pull things together. Helpful, but not required.

We look over what comes in. May have some follow up items or more discussion.

Then we let you know it's good to go and underway.

That’s it.? You’re all done on this.

Time for you to sit back and relax. At least on this item.

Best,

David

For more than a decade, I'm the only expert I know ??specializing in valuation and financial reporting for profits interests in private equity.

Follow, connect, DM, or “Request Services” to keep learning how I can help you with the value of profits interests in private equity.

I answer basic questions for free.

On my profile page you can find many other helpful resources on valuation and financial reporting for profits interests.

P.S. More Details About What You Need to Provide

Here’s more on the information you need to put together for a valuation of profits interests for financial reporting.

??Grant Date(s)

The grant date is the specific day the profits interests were issued (granted) by the company to the employee.? There could be multiple grant dates during the year.

The grant date is typically found in the grant agreement, the legal document that covers the profits interests provided to the employee.

In some cases other dates might need to be considered.

A fair value of profits interests for financial reporting is done as of a specific date, referred to as a valuation date. We use the grant date(s) and work with you to establish appropriate valuation date(s) that comply with GAAP.

? Inside Tip: When there are multiple grant dates during the year, selecting a valuation date can get a little tricky.? It can be tempting to use a valuation date at the end of the year for all the grants. ?Unfortunately this does not work for GAAP. In these situations, we work with you to establish appropriate valuation dates that satisfy financial reporting requirements.

??Capitalization (Cap) Table

The cap table is used in our analysis, along with the capital structure and waterfall, to allocate value to all equity related interests, including the profits interests.

This is a detailed schedule of all the outstanding equity related interests for the company that issued the profits interests.?

This identifies the holder, number, and type of units issued.

As of each expected valuation date (as described above).

Any pool of unissued profits interests should be shown separately.

The cap table is used in our analysis, along with the capital structure and waterfall, to allocate value to all equity related interests, including the profits interests.

Inside Tip: The cap table may be presented in the operating agreement described below. This works, as long it is accurate for the valuation date and has the required level of information.

??Details on Profits Interests Granted

This is additional information on all profits interests issued and outstanding, if not presented in the cap table or elsewhere:

> Holder

> Grant date

> Units (or percentages) granted

> Vesting conditions

> Safe harbor threshold

> Individual or representative grant agreements

An easy way to accomplish this is to provide copies of the complete grant agreements (subject to the Inside Tip just below)

? Inside Tip: In today’s environment of confidentiality and data privacy, it is recommended to exclude (and/or redact) personal identifying information from what you send over.? It’s not needed for this analysis.

???Shareholder Agreements

This is the limited liability company (LLC) operating (or partnership) agreement that pertains to the company that issued the profits interests.

Most recent update, if any, applicable to the valuation date(s).

This is used to define the rights and waterfall relating to the capital structure in the valuation analysis.

Inside Tip: Private equity deal structures can get complicated, with many different legal entities in the organizational structure. However, if not sure which agreements we need just sent them all over and we can figure it out.

??Projected Time to Exit

This is management's best estimate, as of the valuation date, of the potential time to an exit. There may not be an exact period, so a range could also be used.

The actual exit could be something different, just need a reasonable estimate here.

The special valuation methods require this information for the analysis.

??Estimates of Preferences

These are the preferences that would have to be paid, under the waterfall, before distributions would go to other interests.

This should include the amount of unreturned capital and accumulated unpaid preferred return as of the valuation date.

These amounts are used in the valuation method to establish the waterfall and identify proceeds to the profits interests.

??Business (Total Equity) Value

A value of total equity will be needed for each valuation date during the year.

This is the business (enterprise) value, less debt (net of cash).?

Management usually has this information available. We do not need to develop an alternative estimate of business value. Unless necessary.

If there are multiple grant dates for profits interests grants during the year, we help rationalize a strategy to identify total equity value that aligns with GAAP requirements for this purpose.

Inside Tip: If needed, we can help management develop a value for total equity. ?Simple estimates using common methods such as an EBITDA multiple or discounted cash flow method can be used. Keep in mind a recent acquisition can often be used.